February 8, 2010

It’s October 1931

We are now more than two years into the Great Recession, which began in December 2007. In the Great Depression, this was the point where the Fed decided to raise interest rates to keep the dollar from depreciating (after Britain left the gold standard.)

Mr. Bullard of the St. Louis Fed wants to see “at least one month of positive jobs growth” before raising rates. Maybe it will come out tomorrow, but stocks fell sharply today on worries that the recovery is sputtering out:

NEW YORK (AP) — Stocks buckled Thursday under the growing belief that the global economy is weaker than many investors expected and is likely to stop the U.S. labor market from rebounding in the coming months.

. . .

The drop was similar to stumbles the market began having in mid-January. Stocks fell then in response to China’s attempts to curb its overheated growth. Those moves raised fears that the other world economies could suffer as a result. The pullback in stocks worsened as leaders in Washington said they would impose tighter regulations on U.S. banks.

So stocks crashed because investors are worried about Chinese moves to curb demand, and tighter regulation of the banking system. Interestingly, Krugman has recently been calling for a higher value of the yuan (which is a deflationary policy for China) as well as tighter regulation of the banking system. He also favors tariffs on big carbon emitters (i.e. China.)

I still think we will avoid an outright double dip (or perhaps I should say that I infer that the markets think this will be avoided, as I don’t do witchcraft.) But I am increasingly worried about the Japanese scenario (which to his credit, Krugman has repeatedly warned about.) The CBO just put out an estimate of 2.8% NGDP growth in 2011. There is no way to overstate how depressing that number is. During the recovery from the 1981-82 recession we had roughly 10% nominal growth for much of 1983 and 1984. The normal NGDP growth rate has been just over 5% in recent decades. In this recession we fell about 8% below that trend, and could now use some rapid catch-up. Instead, we may fall even farther behind trend.

Why does any of this matter? Consider the following from a study of the Great Depression:

We find that, once we have controlled for lagged output and banking panics, the effects on output of shocks to nominal wages and shocks to prices are roughly equal and opposite. If price effects operating through nonwage channels were important, we would expect to find the effect on output of a change in prices (given wages) to be greater than the effect of a change in nominal wages (given prices). As we find roughly equal effects, our evidence favors the view that sticky wages were the dominant source of nonneutrality.

Let me explain what Steve Silver and I did when we studied the Great Depression. We regressed (differences of logs of) monthly industrial production on monthly wholesale prices and nominal hourly wages. We found higher prices had a positive effective, and higher nominal wages had a negative effect of a similar magnitude. So it looks like real wages were the problem. You can get higher real wages through deflation (for a given nominal wage) or through higher nominal wages (for a given price level.) Either way you get high unemployment.

Actually I tricked you. The quotation above does not come from the time series paper with Steve Silver that I just described, but rather from a different paper that looked at cross-sectional data for many different countries during the Depression. Isn’t it interesting that they got almost the same findings, using a completely different technique. BTW, the authors of the paper I quoted were Kevin Carey, and . . . some fellow named Ben Bernanke.

Late last year I expressed a lot of concern about how difficult it was going to be to get all workers to accept pay cuts that put them 8% below their previous trend line, assuming that NGDP doesn’t fully recover but rather starts a new 5% growth rate from this point forward. I pointed out that NYC teachers, for instance, were about to get a 4% raise negotiated way back in 2005. Little did I imagine that even 8% adjustments wouldn’t be enough. Faster than 5% NGDP growth would allow us to get back to a reasonable unemployment level without painful and prolonged wage cuts. Instead they’re estimating only 2.8% NGDP growth in 2011. So after a painful round of wage cuts workers can look forward to . . . even more painful wage cuts.

I’m not a leftist, but if I was a conspiratorial leftist I would attribute today’s stock crash to investors waking up to the fact that the pain was spreading beyond the labor markets. Here’s what a left-wing Sumner would assume was going through the mind of investors :

“For a while we had the economy in a sweet spot. It was depressed enough to keep labor and other inputs really cheap, but at least we could look forward to steady 5% NGDP growth going forward. Yeah, workers were suffering, but corporate profits were doing alright. But now the hawks at the Fed and ECB and BOJ have gone too far. If NGDP growth slows further, it won’t just be workers suffering; there won’t even be enough revenue to underpin higher corporate profits. And now the Chinese are even tightening. China; the one bright spot in the world economy during 2009! And I just read that the ‘Davos men’ are pressuring China to adopt the Hoover/Mellon strong currency policies. If the China recovery sputters out, who’s going to be the engine of the world economy? I’m all for conservative policies, but not so conservative we end up in a depression.”

I’m not saying that’s what happened on Wall Street recently; just saying a left-wing version of me would entertain that hypothesis.

Part 2. Krugman wants a stronger yuan

Paul Krugman is again attacking the weak yuan policy, using a zero sum exchange rate model that takes no account of how the policy impacts world aggregate demand. But Krugman is not a vulgar protectionist. In the past he carefully noted that the weak yuan would not hurt the US if interest rates weren’t stuck at zero. Normally, the Fed could ease policy to offset any negative effects on AD. Instead, he only seems like a vulgar populist because he has a special “depression economics” model that allows for all sorts of unsavory policy advice once rates hit the zero bound. Unfortunately, he is still wrong for three different reasons.

1. Start with his assumption that currency adjustments are a zero-sum game. If that were true, and it’s not, then the weak yuan should help China and hurt the US. Yes, some other poor countries might also be hurt, but they could offset the effect via devaluation. In contrast, the US and Europe cannot easily devalue without triggering all sorts of international tensions. But even if this view is right, his advice to the Chinese is wrong. China has 1.35 billion mostly poor people. The US has 310 million mostly affluent people. A good liberal like Krugman should argue for a weak yuan, as the Chinese need the money much more than we do.

2. The second thing wrong with Krugman’s argument is that (unless he has become a vulgar protectionist in the last few weeks) he himself notes that it only applies to a situation where the Fed is powerless to boost AD. But even Krugman admits that they aren’t powerless right now. They could set a higher inflation target. They simply don’t want to. So now he wants to impose hardship on millions of poor Chinese workers in export industries because our own Fed (and ECB) are too lazy to lift a finger to boost NGDP growth in the US. Indeed they are just itching to tighten policy further. So even if Krugman isn’t a utilitarian liberal like me, even if (unlike me) he doesn’t care more about the poor in China than the middle class in America, it’s still a bad argument, as the solution isn’t a higher yuan, it’s unconventional monetary stimulus in the US.

3. But it’s even worse than that. Because even if Krugman doesn’t care about the Chinese, and even if you assume the Fed is powerless, a stronger yuan is still a bad policy. Why? Because money isn’t a zero-sum game. Currency policies are also monetary policies. A stronger yuan is a deflationary monetary policy. A weaker yuan is expansionary. Krugman has spoken highly of FDR’s bold expansionary policies undertaken when he took office, even citing a 2008 AER paper by Eggertsson. But the FDR policy that was far and away the most influential at boosting inflation expectations was dollar devaluation. That’s right; he praises his hero FDR for pursuing exactly the sort of “beggar thy neighbor” policy that he wants the Chinese to stop doing. Just to be clear, I understand that China has begun growing briskly again and that at some point they will need to start appreciating the yuan again to prevent overheating. But Krugman was certainly wrong about the yuan in 2009, when China experienced deflation. And the recent stock plunges all over the world, which seemed to follow the Chinese decision to tighten policy in January, should be a shot across the bow of those who want to tighten prematurely. Krugman quite rightly points to the errors of 1937, when the US tightened policy during a period of rapid growth, but also a period when neither the US nor world economy was yet out of depression. Let’s not make the same mistake again. There’s plenty of time to tighten policy when things get a bit better. If the Chinese recovery is real then by late 2010 a higher yuan will probably be appropriate. But it is too soon to tighten now.

If China slows, our recovery will also be threatened, regardless of the fact that US exports to China are relatively modest. China affects the entire world economy. It has a huge effect on East Asia, on Australia, even on capital goods producers in Germany. If the entire world economy slows, it will affect the US.

And the effects are not just from exports, that’s more zero-sum thinking. It will lower the world Wicksellian real interest rate, and that will drag central banks deeper into a Japanese-style liquidity morass.

I hope I am just overreacting to the stock market tonight (it fell 3.1%), and that we get a “strong” jobs number tomorrow. (These days ’strong’ would mean 10% unemployment, and a few hundred jobs gained after 8 million lost.) But please, let’s err on the side of recovery. I haven’t even talked about all the other problems with slow NGDP growth—more banking problems, debt crises in Southern Europe, and lots more. Those who have studied the Great Depression know about all the ugly side effects. And how about this Gideon Rachman’s description of the “best and the brightest” who represent us at Davos:

With the Americans and the Europeans experiencing a crisis of confidence, Davos man was keen to learn from China this year. American businessmen could be heard ruefully contrasting their own “dysfunctional” political system and flaky politicians with China’s decisive and meritocratic leadership.

Oh yes, China has strong leaders who can make the high speed trains get built on time. Wish we had a leader like that here. Our businessmen made many similar comments during the 1930s, but not about China